Attack on Volcker Rule Seen Exaggerating Cost of Disorder

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Jan. 18 (Bloomberg) -- Lobbyists for U.S. banks say a
proposed ban on proprietary trading will cost companies and
investors more than $350 billion. Some economists and fund
managers say the claim is greatly exaggerated.

The impact of the so-called Volcker rule on markets and the
economy is being debated at a congressional hearing today, a
month before the Feb. 13 deadline for comments on a 298-page
plan by regulators to implement the ban. The proposal,
championed by former Federal Reserve Chairman Paul Volcker, 84,
would constrain the largest banks from betting on investments
that could produce big losses.

Lobbying groups, including the Securities Industry and
Financial Markets Association, say the narrow definition of
what's allowed under the proposal will curtail the role of banks
as market-makers, preventing them from purchasing securities
clients want to sell without first finding a buyer. That would
reduce liquidity and increase transaction costs for companies,
according to an industry-funded study.

'Their fears are greatly exaggerated,' said Simon
Johnson, an economics professor at the Massachusetts Institute
of Technology scheduled to testify at the House Financial
Services Committee hearing. 'The industry's claim ignores the
fact that when the largest banks stop doing this kind of
trading, somebody else will step in to do it. And we have to
weigh those costs against the risk of banks blowing up.'

Lobbying Priority

The potential loss of revenue for banks has made pushing
back against the Volcker rule a lobbying priority. Efforts by
Sifma and other groups to modify the proposal come as lenders
already are making less money buying and selling securities.
Trading revenue at JPMorgan Chase & Co., the largest U.S. lender
by assets, dropped 18 percent in the fourth quarter, the bank
reported last week. Citigroup Inc., the third-largest, posted a
10 percent decline yesterday.

The Volcker rule is scheduled to take effect in July, two
years after passage of the Dodd-Frank Act, which incorporated
the restrictions. While a final version of the regulation could
be published within two to three months of the Feb. 13 deadline,
there's a chance details won't be ironed out before the July
deadline, regulators say.

Two studies of the Volcker rule's impact on markets,
commissioned by Sifma, conducted by consulting firm Oliver Wyman
and published last month, don't mention potential benefits. One
report estimated that because investors won't be able to sell
bonds as easily as before, they will lose as much as $315
billion on the value of existing holdings. Borrowing costs for
companies selling new debt would rise by $43 billion a year
because buyers of debt would demand higher premiums for less-
liquid assets, according to the study.

'Faulty Assumptions'

The Oliver Wyman report bases its analysis on an academic
study that looked at the loss of liquidity during the financial
crisis. That exaggerates the impact of the Volcker rule by
assuming it would be as disruptive as the worst recession since
World War II, said Senator Jeff Merkley, an Oregon Democrat
involved in drafting the original law.

'They relied on several faulty assumptions, including
cherry-picking data points from the bottom of the financial
crisis,' Merkley said in an e-mail.

'There might be some liquidity impact on the margins,'
Tarullo said. The impact on markets remaining limited 'depends
on how well regulators do their job implementing the rule and
the degree to how much non-regulated firms pick up where others
leave it aside.'

Representative Barney Frank, the Massachusetts Democrat who
led the Dodd-Frank legislation through the House in 2010 when he
was chairman of the committee, questioned the regulators on
whether they thought they were able to provide the correct
guidelines for distinguishing between prop trading and market
making. Tarullo and the others testifying at the hearing all
answered affirmatively.

Concerns of Republican committee members and bank lobbyists
that regulators would be overzealous in implementation were
overblown, Frank said in a phone interview.

'The notion that anything that advances liquidity is a
good thing, without any regard to stability, is the problem,'
said Frank. 'Much of this liquidity wasn't for customers, but
for the banks to make money for themselves.'

'Lawyer and Psychiatrist'

JPMorgan Chief Executive Officer Jamie Dimon, 55, said last
week that while he supports the aim of the Volcker rule to
prevent excessive risk-taking, regulators have written their
proposal too narrowly.

'If you want to be trading, you have to have a lawyer and
a psychiatrist sitting next to you determining what was your
intent every time you did something,' Dimon said in an
interview with CNBC on Jan. 9.

In their Oct. 11 proposal, the Federal Reserve, Federal
Deposit Insurance Corp., Office of the Comptroller of the
Currency and Securities and Exchange Commission laid out
guidelines for how to distinguish between permitted market-
making and proprietary trading. The regulation allows banks to
use capital to buy and hold securities temporarily in
anticipation of finding a match for the trade later, while
banning them from betting on asset prices without consideration
of client demand.

Burden of Proof

Sifma and other lobbying groups say the burden of proving
they're not prop trading falls on the firm, which will raise
compliance costs and discourage buying and selling for market-
making purposes. Some clients agree. Zane Brown, a fixed-income
strategist at Lord Abbett & Co. in Jersey City, New Jersey, said
his firm, which manages about $100 billion of assets, already
has felt the impact of banks being reluctant to make markets in
anticipation of the Volcker rule.

'Dealers are less willing to carry inventory,' Brown said
in a phone interview. 'So liquidity has gotten much worse in
the last six to nine months. When they don't want to carry
inventory, we can't sell big blocks of bonds to them. They want
to look for a buyer to match the seller first. That lowers the
price because the buyer knows the seller is trying to get out of
the position.'

Other fund managers say the reluctance is the result of
deteriorating market conditions, not fear of pending rules.

'Since the 2008 crisis, the fear of getting stuck with
losses has made the banks less willing to buy less liquid
bonds,' said Sean Simko, who manages $7 billion in bonds at SEI
Investments Co. in Oaks, Pennsylvania. 'With the European
crisis getting worse in the second half of last year, the
reluctance has increased.'

Bid-Ask Spread

Before the financial crisis, the difference between the
market-maker's bid for buying an investment-grade bond such as
one issued by International Business Machines Corp. and the
offer for selling it would be 2 or 3 basis points, Simko said.
Post-crisis, that bid-ask spread has climbed to 20 to 30 basis
points, he said. A basis point is 0.01 percentage point.

Some increased trading cost might be payback for the
underpricing of risk before the crisis, said Charles Whitehead,
a professor of finance law at Cornell University.

'A little friction in the market can be a good thing to
prevent a crisis,' he said in an interview.

Hedge funds could take over the role of market-making from
banks, Whitehead said. Still, while the cost of implementing the
Volcker rule might not be as high as the Oliver Wyman study
predicted, it could exceed the benefits, he said. That's because
by only banning short-term prop trading, the rule doesn't
prevent banks from taking oversize risks with their own money on
longer-term investments.

The alleged failure of the Volcker rule to address the real
causes of the crisis was one of the criticisms cited in a staff
memo sent last week to members of the House Financial Services
Committee in advance of today's hearing and obtained by
Bloomberg News. The committee's staff also pointed to
displeasure by Volcker with the proposed guidelines.

Republican Representatives Spencer Bachus of Alabama and
Randy Neugebauer of Texas, the chairmen of the full committee
and the investigations subcommittee, respectively, have opposed
the proposal from its inception and have pressured regulators to
pull back the scope of the rule.

'Dramatically Reduce Liquidity'

'If the proposed regulations are implemented in their
current form, those regulations will dramatically reduce
liquidity across multiple markets, which will in turn make it
more expensive for businesses to borrow, invest in research and
development and create jobs,' Bachus, along with Republican
Representatives Shelley Moore Capito of West Virginia, Scott
Garrett of New Jersey and Jeb Hensarling of Texas, wrote in a
Dec. 7 letter to regulators.

Volcker said in a November speech in Singapore that the
rule was too complicated and cumbersome, blaming bank lobbyists.
He declined to comment for this story.

Former FDIC Chairman Sheila Bair also criticized the
complexity of the proposal drafted by regulators, urging them to
throw away everything and start again.

'The regulators should think hard about starting over
again with a simple rule based on the underlying economics of
the transaction, not on its label or accounting treatment,'
Bair said in congressional testimony last month. 'If it makes
money from the customer paying fees, interest and commissions,
it passes. If its profitability or loss is based on market
movements, it fails.'

Fund Managers

The four regulators who drafted the rule testified in the
morning session of today's hearing. In the afternoon, Douglas J.
Peebles, chief investment officer at AllianceBernstein LP, the
fund-management unit of French insurer Axa SA, appeared on
behalf of Sifma.

Mark Standish, president and co-CEO of RBC Capital Markets
and representing the Institute of International Bankers, told
the committee that international regulations increasing the
amount of capital banks are required to have would do a better
job of reducing risk in the financial system than the Volcker
rule.

Some fund managers are supporting the banking industry
attack on the Volcker rule because they have close business
relations, MIT's Johnson said. Non-financial companies did the
same when derivatives regulation was being negotiated in 2010,
rallying to the side of banks when their own interests weren't
necessarily aligned with the financial firms, according to
people familiar with the discussions then.

Foreign Governments

Some foreign governments also have criticized the Volcker
rule. Canada and Japan sent letters to the U.S. regulators,
expressing concern that the trading of their sovereign bonds
would suffer if U.S. banks are reluctant to make markets.
Congress exempted U.S. Treasuries from the prop-trading ban.
Sifma will ask regulators to expand the exemption to other top-
rated government bonds such as those issued by Canada, said Rob
Toomey, a managing director at the lobbying organization.

'Congress's intent was not to harm market-making, but the
rules as proposed by regulators are too onerous,' Toomey said.

Even if the Volcker rule does reduce trading in some
markets, that might not be so bad, MIT's Johnson said.

'There's probably excessive trading anyway,' he said.
'Do we need all this trading for the objective of efficient
allocation of capital? Not really. They publish these studies
saying the Volcker rule could hurt social interest, but since
when did the banks start caring about social interest?'